Solvency II: Fair value judgment

The International Accounting Standards Board (IASB) has recently developed fair value proposals that will apply to the valuation of an insurance company’s financial instrument assets and liabilities in its accounts. This article discusses these proposals and considers their interaction with Solvency II.

BackgroundIn October 2008, the IASB’s Expert Advisory Panel produced a report on how to measure and disclose the fair value of financial instruments in markets that are no longer active. The report emphasised that fair value in inactive markets should not be based solely on valuation date market prices; in such circumstances a ‘mark-to-model’ approach was preferable.

In May 2009, the IASB produced an exposure draft on a future fair value measurement standard and, in August 2010, the IASB issued its Staff Draft Fair Value Measurement International Financial Reporting Standard (Draft IFRS). A final standard is expected in 2011. The next two sections set out key elements of this Draft IFRS.

Fair value core principleThe core principle of fair value is ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. Where observed market prices are deemed to represent orderly transactions, observed market prices should be used in determining fair value. For financial instruments with no observable market price, a mark-to-model approach should be used.

Judgment is required for financial instruments where market prices are observable, but the presence of a number of conditions suggests disorderly markets. An illustrative example may be the corporate bond market in late 2008, where observed yields rose significantly over a short time period. At that time, companies found that volumes of trades fell significantly over the same period, with both buyers and sellers unable to transact meaningful-sized trades at observed market prices. The Draft IFRS would require companies to judge whether fair value using the core principle would differ from the observed market price.

The Draft IFRS provides guidance on what constitutes an orderly transaction and how to mark-to-model.

Fair value — other featuresOther aspects of the Draft IFRS include: >>When determining fair value, all available and relevant market prices should be considered >> The use of bid prices in the measurement of financial instrument assets is not required >> The fair value of a liability should reflect the effect of non-performance risk (for example, risk of default) >> The fair value measurement should consider the most advantageous market, which maximises the value of the asset or minimises the value of the liability >> A three-level hierarchy is required to determining fair value and disclosure: Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly Level 3: Unobservable inputs for the asset or liability.

Aligning Solvency II with fair valueUnder the QIS5 specification, asset valuations are generally linked to IFRS valuations. However, to date, the requirements relating to the economic calibration of the liabilities within Solvency II appear to have been developed independently of the fair value developments above. This creates the risk that an internally consistent Solvency II economic balance sheet will not be achieved.

We have developed an approach to the economic calibration within Level 2 Implementing Measures (described below), assuming the preference is to achieve internal consistency. Alternatively, a greater reliance could be placed on Solvency II Pillars 2 and 3.

1. Financial instrument assets should be measured using the IASB’s fair value core principleGiven that a large proportion of the assets held by insurance companies are financial instruments, it would be helpful for the insurance industry to develop common approaches for assessing whether markets are judged to be disorderly and, if so, how fair value would be determined.

2. Assets held to match insurance liabilities should be measured using mid-prices In recent years, existing accounting and regulatory standards have required the use of bid prices, not mid-prices. The valuation of liability rules within Solvency I and existing IFRS have generally permitted the use of a consistent liability discount rate. With the Solvency II discount rate equal to a ‘risk-free rate’ typically based on mid-prices and independent of an insurer’s assets held, measuring financial instrument assets at mid-price would remove an accounting mismatch.

3. The economic calibration of insurance liabilities should be based on the fair value core principleThe approach to the economic calibration of insurance liabilities should be aligned with that required in the Draft IFRS, to avoid an accounting mismatch.

A specific instance relates to the requirement for determining the illiquidity premium component of the liability discount rate. In extreme market conditions where levels of asset illiquidity premia are high, the formula applied in the QIS5 specification would require insurers to apply a market-calibrated illiquidity premium regardless of whether observable market prices represent orderly transactions. However, the illiquidity premium implicit within the fair value core principle may differ significantly from that calculated using the QIS5 formula.

4. The economic calibration of insurance liabilities should use all available and reliable market dataThis would reduce the dependence on extrapolation techniques in determining the risk-free rate, particularly in less-developed markets where government bonds are often available at much longer durations than swaps.

5. The economic calibration of insurance liabilities should use the most advantageous marketWhere there is more than one available and reliable market instrument providing a good match for insurance liabilities, this principle would enable calibration to the instrument that minimises the value of the liability. This reduces the risk of any one calibration instrument being subject to unusually high demand simply because it forms the basis of the economic calibration of liabilities.

6. The economic calibration of insurance liabilities should permit a small amount of credit risk in the calibration instrumentWe advocate calibrating to an actual low-credit risk market instrument that is readily available and provides a good match for the insurance liabilities (eg. collateralised swaps or government bonds issued by countries controlling their own money supply), without amendment to notionally remove the instrument’s credit risk. We accept that this principle is contentious; reasons for our preference over the alternative of constructing a hypothetical ‘100%-creditrisk- free rate curve’ include the following: >>It reflects the price of a viable low-risk asset liability management (ALM) strategy. This is of relevance to insurers when assessing performance against the ALM strategy they have actually undertaken. This should also be of relevance to regulators in a run-off context >> It is more realistic as well as more reliable than a hypothetical ‘100%-credit-risk-free rate curve’ >> It is easier for practitioners to calibrate to >> The residual credit risks can be allowed for within additional capital requirements instead of the market-consistent liability >> It is more consistent with fair value developments, recognising that insurance liabilities are not 100%-credit-risk-free.

7. The measurement of financial instrument liabilities should be at fair valueThis helps ensure consistency with the rest of the valuation and, in orderly markets, represents the value that insurers can buy back debt. This approach would require a new interpretation of Article 75/1(b) of the Solvency II Directive.

8. Disclosure requirements should include details of the calibration asset used to measure the insurance liability, including a three-level hierarchyThis would indicate the materiality of the judgment applied to the economic calibration of insurance liabilities.

Advantages of our proposalsWe believe the above approach would: >>Enhance the usefulness of the Solvency II Pillar 1 calculation, by ensuring greater consistency of the measurement of assets and liabilities >> Limit the administrative burden on insurance companies, by better aligning Solvency II with future IFRS >> Move some of the prudence from the Pillar 1 balance sheet into the capital requirements >> Make it easier for the insurance industry to communicate financial and regulatory reporting concepts to users >> Enhance financial stability and fair and stable markets >> Encourage the use of judgment during financial crises where markets rapidly become illiquid, accompanied by relevant disclosure.

However, we believe the industry would need to develop these proposals further so that they could be implemented in a practical and consistent way. This would help stakeholders understand these proposals and better interpret financial statements.